Why co-owners need one

Say two owners each own half of a Missouri LLC. One dies. Under Missouri law, the owner who died stops being a member. The heir who inherits the share does not become a member either. That takes the operating agreement’s permission or the written consent of all members. Now the surviving owner runs the company next to an estate. The estate gets half the money but has no vote. Neither side has a way out that both can accept.

A buy-sell agreement solves this before it happens. It is a contract among the owners. It can sit inside the operating agreement or stand on its own. It names the events that trigger a buyout, who buys, how the price is set, and how the money is paid.

The events that trigger a buyout

• Death. The most common trigger, and the easiest to pay for with life insurance.
• Disability. Needs a clear definition: how long it lasts, and who confirms it. Otherwise it leads to a lawsuit.
• Retirement or leaving by choice. Often comes with a notice period and payments over time.
• Firing for cause. Often priced at a discount, with the causes spelled out.
• Divorce. Keeps a share awarded to an ex-spouse from staying outside the owner group.
• Bankruptcy or a creditor’s claim. Lets the other owners buy the share before a creditor ends up holding it.
• Deadlock. A shotgun or auction clause breaks the tie. Under a shotgun clause, one owner names a price. The other must then buy or sell at that price.

Setting the price

The price clause causes more buy-sell fights than any other. There are three common ways to set it. Each one can fail.

Federal estate tax adds a limit. Under federal tax law (26 U.S.C. § 2703), a buy-sell price is ignored when valuing the business for estate and gift tax unless the deal passes three tests:

• It is a real business arrangement.
• It is not a way to pass the business to family for less than full value.
• Its terms are like those strangers would agree to in a similar deal.

So a low price set between relatives may bind the owners and still not count for tax. Take that question to your estate planner and CPA.

Who buys, and how it is paid for

In a cross-purchase agreement, the other owners buy the share themselves. In an entity redemption, the company buys the share back. Some agreements give the company the first chance and the owners the second. The choice affects taxes and who must come up with the cash. Make it with your accountant at the table.

Funding is where good agreements fail. Life insurance pays for a buyout at death. Disability buyout insurance covers disability. Buyouts for retirement or leaving are usually paid over time under a promissory note. The note is backed by the share being bought, with payments the business can really afford. An agreement that requires a buyout nobody can pay for is a lawsuit waiting to happen.

Reviewing an agreement you already have

Buy-sell agreements age badly. Harjot Singh Padda, JD, reviews them for common problems:

• A price that was never updated.
• Insurance that lapsed or no longer matches the value.
• Triggers that do not match the operating agreement.
• Definitions of disability or cause that invite an argument.

Mr. Padda also checks that the agreement fits your succession plan instead of working against it. If an owner has already left and the others disagree about the price, it is a dispute, not a drafting job. See partnership and shareholder disputes.

Common questions

Related reading

• Operating agreements
• Business succession planning
• Partnership and shareholder disputes
• Business law practice